Martin Massey outlines the stages and processes necessary for an optimal risk financing programme

Organisations, and the environment within which they operate, change over time and, more importantly, so can both their attitude and ability to retain risk.

Many organisations are seeing their risk profile, insurance costs, and coverage availability change through such factors as acquisitions and disposals, and, in recent years in particular, through market cycle fluctuations.

But whether it be a positive or a negative swing in the business environment, the risk manager needs to find an optimal response to risk retention and risk transfer.

The role of a risk manager 30 years ago was primarily negotiating the most insurance coverage for the least price. In the hardening risk transfer market, this cost-control mentality prompts risk managers to retain more risk. One of the key decisions is how to decide how much to retain and how much to transfer.

Some of the key questions that the risk manager will need to address in answering whether the retention strategy is optimal include the following:

- How much risk can the organisation safely retain?

- What programme structure, (deductibles, limits, quota-share retentions etc), would minimise the total cost of risk?

- If the retention is increased, will the premium savings justify the additional risk?

- How much capital should the organisation commit, for example via its captive insurance subsidiary, to underwrite the retained risk?

In answering the above questions there are in fact only two key issues that the risk manager needs to determine. First, what programme structure will have the minimum expected cost of risk, while keeping volatility within acceptable bounds? And second, what level of risk-bearing capital will be needed to be cost-efficiently allocated between risk retention and risk transfer?

A Risk financing framework

With the change in the environment in which organisations operate, comes increased risk to which they are exposed. Increasingly these will be economic risks, rather than areas of risk that are traditionally considered to be insurable. A framework is set out in Fig 1, which illustrates a typical risk manager's situation.

Initially a risk manager should seek to optimise its insurable risks A and D, its corporate retentions, both group-wide and for the main business units, specifically focusing on A (its key insurable risks, such as property damage, business interruption and general liability risk classes).

The secondary objective is to minimise the total cost of risk, including residual risk (ie that above available insurance capacity C). This should be assessed for each risk class so that appropriate recommendations can be made for appropriate limits (ie B), which could potentially have an impact upon the advice on overall retentions, assuming either a limited capacity and/or excessive cost constraints of insurance purchase.

Having developed a framework, the first key consideration is to understand the risk bearing capacity of the organisation.

Risk-bearing capacity

Before discussing how to optimise risk retention and risk transfer it is important to understand what constraints the organisation may have in terms of its ability to retain risk. In optimising the organisation's risk retention strategy the risk manager needs to understand the risk-bearing capacity of the organisation. Despite the apparent diversity of risk management decisions at various levels of the organisation, ultimately each of them must facilitate the implementation of corporate financial goals.

To give a real-life example, a company took on large amounts of debt to finance an aggressive business expansion. Under pressure to free up more cash, the risk manager decided to retain significantly more risk and save some insurance premium. What he failed to recognise, though, was that the burden of interest expense left little room for volatility in the organisation's cash flows. The combination of high risk retention and tight cash flows increased the risk of defaulting on the debt-servicing obligation. Although this erosion of creditworthiness was not quite transparent to the creditors, even fairly modest losses would have attracted the credit analysts' attention and sent the company's rating down.

In general, there are four main components to the risk retention limits:

- Strength of the balance sheet
- Level and consistency of earnings
- Liquidity
- Credit rating and loan covenant compliance.

In practice, as noted above, there are practical limits to the amount of self insurance that can economically be undertaken. As the scale of loss rises and the possibility of loss reduces, the trade-off from self insurance becomes more uncertain, and thus risk transfer becomes more advantageous. However, in the harder insurance markets, organisations are forced either to absorb huge premium increases, or else drastically elevate the retention levels.

Therefore organisations need to assess their risk-bearing capability.

An important issue in defining that risk-bearing capacity is in relation to insurable risks. The corporate risk-bearing capacity can be defined as a measure of the amount of loss a company can withstand above its currently budgeted (and expected) amounts for insurable loss and insurance expense, without seriously impairing the integrity of important financial ratios and key performance measures.

Without going into detailed explanations of the alternative methodologies, it is important to note that, in building a decision-making framework, an organisation should really consider developing a dynamic financial approach. This is because traditional risk tolerance approaches model the impact of shock losses on corporate financial results - actual or pro-forma. Under these 'static' approaches, volatile businesses would appear to have the same tolerance of risk as their more stable counterparts.

Instead of focusing on a single 'static' set of financial statements, a dynamic approach would study the impact of shock losses under a large number of plausible financial scenarios, thereby providing a more realistic assessment of an organisation's ability to retain risk.

Risk transfer and the insurance market

The main rationale of risk transfer is that, having mitigated its non-core risks (for example hazard, liability, financial risks), an organisation can assume a more aggressive (and riskier) business strategy with a higher return potential. With that, the risks are effectively swapped, with near-term 'nuisance' risks traded for strategically critical exposures, in order to maintain the company's long-term competitiveness.

However, barring extreme loss outcomes, it usually costs more to transfer risk than to retain it. Moreover, under the present hard market conditions, the cost of risk transfer increases and capacity reduces, thus making it more economic to retain a greater proportion of the risk directly.

Organisations need to consider the dynamics of insurance market pricing in optimising the risk retention/transfer decision and consider carefully the benefits of risk transfer. If properly applied, risk transfer can improve the credit terms and help expand the capital base of the organisation, leading to a greater return on equity capital.

Developing risk retention strategies

Risk retention may take different forms - from using working capital to pay for relatively small losses (for example within the deductible layer) - to complex retention vehicles, such as captive insurance subsidiaries.

Increasing risk retention in hard market conditions generally leads to a lower expected cost of risk (defined as the expected cost of retained losses and the cost of risk transfer). However, it also tends to lead to greater volatility. In other words, reduction of the expected cost of risk and volatility reduction are largely opposing goals - one is primarily achieved at the expense of the other.

However, to lower the expected cost of risk, one does not always have to retain more risk. Instead, one should first try to maximise the efficiency of the risk-financing programme. What do we mean by that? A risk-financing programme is said to be cost-efficient if, relative to alternative programme structures with similar volatility parameters, it achieves a lower expected cost of risk. A logical approach to greater cost efficiency is programme optimisation - finding such a combination of retention variables (for example deductibles and attachment points for a captive's retention) that would minimise the expected cost of risk without increasing the residual volatility. To graphically demonstrate this concept, a number of possible risk-financing programmes can be plotted on a chart, based on their volatility and expected cost of risk (see Fig 2). Then the plotted points' lower boundary, often called the efficiency frontier, would consist of cost-efficient programmes.

The hypothetical situation shown in Fig 2 shows an optimisation output for a combination of four risk classes: - ie taking a portfolio approach.

A number of strategies have been developed from 'low' to 'high' representing retention combinations on the efficiency boundary. The outputs shows clearly that an organisation can move to the low strategy from its current retention structure by reducing the cost of risk, while keeping the same level of volatility. But should it take increased retentions to the medium or high risk strategies, where there are potentially large additional cost of savings?

Capital efficiency

Before determining which combination of retentions is optimal, another cost of risk financing needs to be added in: the cost of risk bearing capital. In my own consulting practice, we often see overcapitalised captive insurance subsidiaries - ones that carry too little risk relative to the size of the surplus.

A risk-financing programme is said to be capital-efficient if it maximises the performance of risk-bearing capital. The total expected cost of risk results from adding the cost of risk-bearing capital to the expected losses and risk transfer costs for all the cost-efficient solutions. The goal is to find a programme that minimises the total expected cost of risk.

Optimum strategies

Having developed optimum strategies and calculated the cost of risk for each, the risk bearing capacity for each option still needs to be superimposed to determine whether the organisation should move to the medium or high strategy as outlined above. There are various methods to help ascertain whether the strategy is within the organisation's risk bearing capacity.

In general, it should not impinge on the organisation's ability to meet its contractual obligations and maintain its earning potential.

Structuring an optimum risk-retention strategy requires deep understanding of the way the organisation functions. It involves a lot of stochastic modelling to capture the relationship between the variables and the main revenue, cost and risk drivers of the company as a whole. It is a complex task but the benefits are obvious, and make this process worth the effort.

In conclusion, a risk-financing programme is optimal when it:

- Aligns itself with the corporate strategic goals

- Enhances the corporate capital structure by keeping cash-flow and earnings volatility within the desirable bounds

- Maximises its cost efficiency and capital efficiency.